Appendix – Financial Math

LEARNING OBJECTIVES CONTENT AREAS

1 | Calculate the five variables in a time value of Time Value of Money

money formula.
2 | Determine effective interest rates.

INTRODUCTION
Financial planning requires forecasting the future, while using assumptions based on the past. Ultimately, the
objective is to maximize wealth, without exceeding an individual’s risk tolerance and constraints.
A good example is retirement planning. Retirement planning necessitates estimating life expectancy, retirement
age, interest rates during and before retirement. Income sources, income amounts and desired lifestyle must also be
projected, along with inflation. This requires financial calculations to account for time value of money.
This chapter is a review of basic time value which is essential for nearly all aspects of financial planning. In most
cases, a financial calculator or computer software program will be used to calculate an answer. However, before
inputting data, the type of calculation required must be understood. In other words, the financial advisor must first
determine the problem, and then, using a calculator or computer software, find the numerical answer.
While the underlying formulas are included, the emphasis will be on using a calculator that can perform financial
functions.

TIME VALUE OF MONEY

1 | Calculate the five variables in a time value of money formula.

2 | Determine effective interest rates.

Given the choice between receiving $1,000 today or $1,000 in one year, rational investors will take the money
now. This concept, known as the Rational Expectation Hypothesis, states that investors act rationally, in their own
economic self-interest. An investor receiving $1,000 today has an opportunity to spend it or invest it and realize
a greater sum. Investing the $1,000 in an instrument providing a guaranteed rate of return (e.g., a term deposit,
Guaranteed Investment Certificate or a Canada Savings Bond) will mean the investor will have more than $1,000
in one year. How much more depends on the rate of return earned on the investment. If the investment pays 6%
annually, the investor will have $1,060 in one year. In other words, the future value of $1,000 invested at 6% for one
year equals $1,060. Conversely, if you are asked to pay now for a future return, you would obviously pay less, since
you are forgoing interest that could be earned. In the above example, the rational investor would only pay $1,000
for a future amount of $1,060. Calculating what to pay today for a future amount is known as present value.

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A•2 FUNDAMENTALS OF FINANCIAL PLANNING

GENERAL RULE
As long as investment opportunities exist that can earn interest, the future value amount will always be greater
than the present value. Similarly, present value amounts are always less than future value amounts. If this is not
true of your calculations, you have an error. Financial advisors can expect to face a number of questions or problems
involving the time value of money. Consider the following:
• If a client invests $1,000 today at 4% compounded annually, what will it be worth in 10 years?
• If I invest $15,500 in my RRSP each year for 20 years at 9% compounded annually, how much will I have toward
financing my retirement?
• How much would have to be set aside today in order to finance a child’s four years of university? Assume that
the child will start in five years and that all deposits will earn 7% compounded annually. Each year of university
will cost $10,000.
• The department store tells me that they only charge 20%, but I notice that they compound this amount daily.
Is that really only 20%?
• The bank will lend me the money at 10%, spread over a four-year period, but compounded monthly. What will
my payments be? If I want to pay off the loan in two years, what will my monthly payments be?
• I want to buy a house. Our family budget can stand payments of about $2,000 a month. The bank will give me a
25-year mortgage at 8.5%. About what price level should I be looking, if I have a $10,000 down payment?

Answering the above questions will require a financial calculator, computer program or financial tables and an
understanding of financial math. In this chapter, emphasis will be placed on structuring the solution and using a
financial calculator.
A few notes on the use of a financial calculator follow.

NOTES ON USING A FINANCIAL CALCULATOR

Most financial planning requires present value and future value calculations. These can be more easily performed
using a financial calculator. Price and complexity of functions (the size of the instruction manual) do not
necessarily equate to ease of performance or a calculator’s added value. A calculator with the function keys of N,
I, PV, PMT and FV will usually prove adequate.
General Rules:
1. Always clear the calculator before each operation (AC/ON, CE/C).
2. Put the calculator in FIN (finance) mode (this may not apply for all calculators).
3. Small differences between formula calculations and calculations done with a financial calculator may arise,
due to rounding errors. The general rule is to set your calculator to the maximum number of decimal places
allowed and then round off your final answer to two decimal places.
4. Before you start a time value calculation, you have to determine whether the first periodic payment starts
at the beginning or at the end of the first period. For example, the end mode is used for ordinary annuities,
and most mortgages and loans. The beginning mode, on the other hand, would be used for an annuity due
where payments start immediately.
5. The 2nd function button allows you to access those functions written on the body of the calculator, above
the key.
6. Data does not have to be entered in any specific order.
7. The calculator automatically converts interest to a decimal form. Enter 10 for 10%, not 0.10.
8. Some calculators require you to enter the compute (CPT or COMP) key before providing an answer.

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 APPENDIX | FINANCIAL MATH A•3

TIME VALUE BASICS

All present value and future value calculations involve five main variables:
1. Total number of compounding N periods
2. Annual interest rate I or I/Y
3. Present value PV or current value
4. Payment amount PMT
5. Future value FV

Other variables that must be considered are:

• Number of payments per year (p/yr); and
• Whether the first periodic payment is at the beginning or the end of the first period (beg/end).

Please note that there are many different types of financial calculators available on the market. You must read your
calculator manual to determine how specific variables are to be entered into your own calculator. The calculations
shown below are based on the Sharp EL-738 financial calculator.

INTEREST RATES
What is interest? The short answer is “rent,” the amount demanded by the suppliers of capital. Interest may be
simple or compound. When specific reference is made to simple interest, interest is calculated only on the principal
amount. With compound interest, interest is calculated on both the principal and any accumulated interest. As a
general rule, when interest is stated it is assumed to be on an annual basis and presumed to be compounded. To
demonstrate the difference, consider the following example:

EXAMPLE
Suppose $10 is invested for two years at 10% per annum. Calculate the amount of interest that would be earned
from simple interest and from compounded interest.
Simple Interest:
Year 1 $100 invested at 10% = $10 in interest
Year 2 $100 invested at 10% = $10 in interest
Total interest = $20

Compound Interest:
Year 1 $100 invested at 10% = $10 in interest
Year 2 $110 invested at 10% = $11 in interest
Total interest = $21

How is interest calculated? The rate of interest demanded by suppliers of capital (i.e., investors) is dependent upon:
• The real rate of return;
• The expected inflation rate; and
• A risk premium.

The real rate of return is the return demanded by investors, if there were no inflation and no risk associated with the
investment. Historically this has been around 2% to 3%. The Treasury bill rate closely approximates the real rate

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A•4 FUNDAMENTALS OF FINANCIAL PLANNING

of return, plus the expected inflation rate and is often called the risk-free rate. It is said to be risk free in that the
Treasury bills are short-term, default-free, government-backed securities, but they do provide a positive return.
The risk premium is a variable amount that is added to the risk-free rate to compensate investors for taking on
additional amounts of risk. For example, it is quite common for bankers offering lines of credit to charge clients
“prime plus.” The “prime” represents the banker’s basic cost of capital, and the “plus” represents the banker’s
perception of the client’s degree of default risk (a risk premium). If the banker perceives the client to be a good
credit risk, the rate charged may be prime plus 0.5%; if the credit risk is higher, the banker may charge prime
plus 2%.
The discount rate used in present value calculations is the opposite of interest rate. It is the interest rate that
reduces a future amount. What may make this term confusing is that “discount rate,” “the rate on securities of
similar risk” and “interest rate” are often used interchangeably.

FUTURE VALUE OF A SINGLE AMOUNT

In general, a one year investment will be worth the principal, plus the interest on the principal. For example, $5,000
invested for one year at 8% will be worth:
Total Future Value = Principal + Interest
= $5,000 + ($5,000 × 0.08)
= $5,400
The above future value calculation can be simplified to:

FV = PV + PV × ( i )

Where:
FV = the future value of any single amount
PV = the present value of any amount
i = the interest rate, expressed as a percentage

Using a little algebra, the formula can be simplified to:

n
FV = PV × (1 + i )

Where:
n = the number of periods

Solution:
FV = $5,000 (1 + 0.08)1
= $5,000 (1.08)
= $5,400

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 APPENDIX | FINANCIAL MATH A•5

MULTIPLE PERIODS
For each successive year, interest is earned on the initial $5,000, as well as on the previously accumulated interest
(compound interest). Therefore, by the end of Year 2 the investment would be worth:

FV = $5,000 (1.08)2
= $5,000 × (1.08) × (1.08)
= $5,832

RAISING A NUMBER TO A HIGHER POWER

In the above calculation (1.08)2 can be done in one of three ways:

METHOD 1: MANUAL CALCULATION

(1.08)(1.08) = 1.1664, then apply the formula:
FV = PV (1 + i)n
= $5,000 (1.1664) = $5,832

METHOD 2: RAISING A VALUE TO A HIGHER POWER

Key Touch Display

1.08 2 ,Y
nd x
0.00
2 = 1.1664

Applying the formula:

FV = PV (1 + i)n
= $5,000 (1.1664)
= $5,832

METHOD 3: USING A FINANCIAL CALCULATOR (REMEMBER TO CLEAR THE CALCULATOR FIRST):

Keep in mind that as long as four variables are known in a time value calculation, the variable can always be
calculated. In this scenario, the number of compounding periods N, the interest rate I, present value PV and the
payment PMT are known. The future value FV must be computed CPT.

Key Touch Display

2 N 2
8 1 8
5,000 PV 5,000
0 PMT 0
CPT FV –5,832

Note that the negative number represents a cash outfllow.

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A•6 FUNDAMENTALS OF FINANCIAL PLANNING

EXAMPLE: FUTURE VALUE — SINGLE AMOUNTS

1. If a client invests $1,000 at 4% for one year, how much will the client have after one year?
2. If you invest $1,000 at 4% for two years, assuming that the amounts are compounded annually, how much, in
total, will you have after two years?
3. If you invest $1,000 at 4% for 10 years, assuming compound interest, how much will you have after 10 years?

Solutions:
n
FV = PV × (1 + i )

METHOD 1:
FV = $1,000 (1 + 0.04)1
= $1,000 (1.04)
= $1,040

FV = $1,000 (1 + 0.04)2
= $1,000 (1.04) (1.04)
= $1,081.60

FV = $1,000 (1 + 0.04)10
= $1,000 (1.04) (1.04) (1.04) (1.04) etc.
= $1,480.24

Alternatively, to raise a number to a higher power:

METHOD 2: (1.04)2 OR (1.04)(1.04) IS THE SAME AS:

Key Touch Display

1.04 2 ,Y
nd x
0.00
2 = 1.0816
× 1,000 = 1,081.60

(1.04)10 IS THE SAME AS:

Key Touch Display

1.04 2nd, Yx 0.00
10 = 1.48024
× 1,000 = 1,480.24

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 APPENDIX | FINANCIAL MATH A•7

METHOD 3: USING A FINANCIAL CALCULATOR:

Key Touch Display

1 N 1
4 1 4
1,000 PV 1,000
0 PMT 0
CPT FV –1,040.00

Key Touch Display

2 N 2
4 1 4
1,000 PV 1,000
0 PMT 0
CPT FV –1,081.60

Key Touch Display

10 N 10
4 1 4
1,000 PV 1,000
0 PMT 0
CPT FV –1,480.24

MULTIPLE COMPOUNDING
All the above examples assumed that interest was compounded annually. This may not always be the case. The
i and n values in the future value formula have to be adjusted when compounding occurs more than once a year.
When the interest rate is quoted as an annual rate, but there is multiple compounding, the future value formula is
modified to:
n× f
Future Value = PV × (1 + i f )

Where i is the annual interest rate and f is the frequency of compounding periods in a year and n is the number of
compounding years.

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A•8 FUNDAMENTALS OF FINANCIAL PLANNING

EXAMPLE
What is the future value of $100 invested at 10% for one year, with interest compounded semi‑annually?
Solution: Interest is compounded twice a year (semi-annually):
nf = 1×2=2
i/f = 10/2 = 5%

Solving for the future value:

FV = $100 (1 + 0.05)2
FV = $100 (1.05)2

(Recall that to raise (1.05) to the power of 2: Press: 1.05, then yx, then 2, then =)
FV = $100 (1 + 0.05)2
FV = $110.25

Using a financial calculator:

Key Touch Display

2 N 2
5 1 5
100 PV 100
0 PMT 0
CPT FV –110.25

Rule: Multiple compounding always results in a higher future value than annual compounding (or you have an
error), and the more frequent the compounding periods the higher the future value.

EXAMPLE
Suppose three investors each had $100 to invest for 50 years. The first investor chose Treasury bills. These
yielded, on average, about 6.5% compounded monthly over the past 45 years. The second investor decided to
put the $100 into a mutual fund that tracked the S&P/TSX Composite Index. Over the same time period the
return on the S&P/TSX Composite Index has averaged about 10.5% per year, compounded monthly. The third
investor had the Midas touch and moved the investment between Treasury bills and the S&P/TSX Composite
Index every month and in the process earned 3% each month. How much will each investor have at the end of
50 years?
Solution: Future Value = PV × (1 + i/f)nf
1. $100 × (1 + 0.065/12)50 x 12 = $100 × (1.0054167)600 = $2,556.51
2. $100 × (1 + 0.105/12)50 x 12 = $100 × (1.00875)600 = $18,626.39
3. $100 × (1 + 0.03)600 = 5,038,888,600

Calculator solutions. In this case, three steps are required to arrive at the answer. In the first step, the number of
periods and the interest rate per compounding period is calculated (this is common to all calculator problems). The
second step is to raise a number to a higher power (you could manually multiply the values 600 times), and the last
step is to complete the calculation.
Instead of showing all three sets of calculations, the first calculation will illustrate the process.

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 APPENDIX | FINANCIAL MATH A•9

STEP 1: CLEAR THE CALCULATOR

Key Touch Display

50 x 50
12 = 600 (The number of periods, set aside)
0.065 ÷ 0.065
12 = 0.0054167 (Interest per compounding period)
0.0054167 + 0.0054167
I = 1.0054167

STEP 2: RAISING ONE PLUS THE INTEREST RATE FACTOR TO THE POWER OF 600

Key Touch Display

1.0054167 2 , Y , 600 =
nd x
25.563645

STEP 3: COMPLETING THE CALCULATION

100 × 25.565645 = $2,556.56

The small differences are due to rounding errors.

PROBLEM NO. 1: USING A FINANCIAL CALCULATOR

Key Touch Display

600 N 600 (12 × 50)
0.54167 I 0.54167 (6.5% / 12)
100 PV 100
0 PMT 0
CPT FV –2,556.56

PROBLEM NO. 2: USING A FINANCIAL CALCULATOR

Key Touch Display

600 N 600 (12 × 50)
0.875 I 0.875 (10.5% / 12)
100 PV 100
0 PMT 0
CPT FV –18,626.39

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A • 10 FUNDAMENTALS OF FINANCIAL PLANNING

PROBLEM NO. 3: USING A FINANCIAL CALCULATOR

Key Touch Display

600 N 600 (12 × 50)
3 I 3 (3% on a per period basis)
100 PV 100
0 PMT 0
CPT FV –5,038,889,365

EFFECTIVE INTEREST RATES

As seen from the above calculations, the quoted or stated annual percentage rate (APR) may be different from the
actual or effective annual interest rate (EAR), which is very significant when calculating the real cost of credit cards.
To compare different investments or interest rates, the effective interest rate must be calculated. The formula for
the effective annual interest rate is as follows:
n× f
EAR =  1 + (Quoted Annual Rate f ) −1

While the formula appears complicated, it really represents the latter part of the Future Value Formula, used above
(i.e., FV = PV × (1 + i/f )nf )
Where:
i = the quoted rate
f = frequency of compounding periods
i/f = the “interest rate” per compounding period
nf = the total number of compounding periods

For example, if three banks advertise savings accounts with interest rates of:
1. 9.75% compounded daily;
2. 10.0% compounded quarterly; and
3. 10.25% compounded annually;

Which would give an investor the best return?

The effective annual rates (the actual rate earned) will be:
1. (1 + 0.0975/365)1 × 365 – 1 = 10.24%
2. (1 + 0.10/4)1 × 4 – 1 = 10.38%
3. (1 + 0.1025/1)1 × 1 – 1 = 10.25%

The above example illustrates two things: first, the highest quoted rate is not necessarily the best; and, multi-period
compounding can lead to a significant difference between the stated rate and the actual rate.
These problems can also be solved using a financial calculator that has a built-in “EFF” function. (The following
procedure assumes that the “EFF” is a second-level function.)

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 APPENDIX | FINANCIAL MATH A • 11

BANK NO. 1:

Key Touch Display

365 (x,y) 0.00
9.75 2 , EFF
nd
10.24

BANK NO. 2:

Key Touch Display

4 (x,y) 0.00
10 2 , EFF
nd
10.38

BANK NO. 3:

Key Touch Display

1 (x,y) 0.00
10.25 2 , EFF
nd
10.25

Rule: When the compounding period is one year, the effective annual rate is equal to the quoted rate. When there
are multiple compounding periods, the effective rate must always be greater than the annual quoted rate.

PRESENT VALUE OF A SINGLE AMOUNT

Frequently financial advisors are presented with problems where the future value is known, but not the present
value. Calculating the present value (i.e., the present price) simply involves rearranging the future value formula:
n
FV = PV × (1 + i )

1
FV n
= PV
(1 + i )
FV
PV = n
(1 + i )
Where “i” is the discount rate and “n” represents the number of annual compounding periods. The following exercise
demonstrates the calculations:
Exercise: Calculate the present value of:
1. $1,480.24 to be received in 10 years, discounted at 4%.
2. $1,060 to be received in one year, discounted at 6%.
3. Which would you rather have: $5,000 today or a guaranteed $7,000 in five years’ time? Assume that you can
get 8% annually on a five-year term deposit, and you have no immediate need for the funds.

SOLUTION FOR PRESENT VALUE EXERCISE 1:

$1,480.24
PV = 10
(1.04)
= 999.99711 or $1,000 (small rounding error )

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A • 12 FUNDAMENTALS OF FINANCIAL PLANNING

OR, USING A FINANCIAL CALCULATOR:

Key Touch Display

10 N 10
4 I 4
0 PMT 0
1,480.24 FV 1480.24
CPT PV –999.997 or –1,000

SOLUTION FOR PRESENT VALUE EXERCISE 2:

This is a thinly disguised bond question. The investor would receive $1,000 par and $60 in interest.
$1,060
PV = 1
(1 + 0.06)
= $1,000

The above illustrates that when the market interest rate on a bond equals the coupon, the bond will trade at par.
If interest rates rise, the discount rate increases and the bond price falls.

SOLUTION FOR PRESENT VALUE EXERCISE 3:

This is an interesting question, as it can be solved in two ways. Find the present value of $7,000 and compare it
to the $5,000 (choosing the one that is higher). Or, by comparing future values and taking the one that gives the
higher result.
$7,000
PV = 5
(1 + 0.08)
$7,000
= = $4,764.08 versus $5,000
1.4693

Answer: Take the $5,000 lump sum amount today.

USING A FINANCIAL CALCULATOR TO FIND THE PRESENT VALUE OF $7,000:

Key Touch Display

5 N 5
8 I 8
0 PMT 0
7,000 FV 7,000
CPT PV –4,764.08

ALTERNATIVELY, COMPARING FUTURE VALUES:

FV = $5,000 (1 + 0.08)5 = $7,346.64

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 APPENDIX | FINANCIAL MATH A • 13

USING A FINANCIAL CALCULATOR THAT CALCULATES THE FUTURE VALUE OF $5,000 IN 5 YEARS:

Key Touch Display

5 N 5
8 I 8
5,000 PV 5,000
0 PMT 0
CPT FV –7,346.64

Answer: Take the $5,000 amount today as the funds will grow to a higher amount (i.e., $7,346.58) versus the
guaranteed $7,000 in five years’ time.
The above illustrates that there are many ways to solve problems.

PRESENT OR FUTURE VALUES OF UNEVEN AMOUNTS

Suppose a cash flow is $1,000 in Year 1, $2,000 in Year 2 and $500 in Year 3. What are the future and present values
of these cash flows, if interest rates are 10%?
To solve the series, a financial advisor would have to treat each cash flow separately, and then add them together.
For example, to solve for the future value:
0.........................................1 .................................2 ..................................3
1,0002,000 500

$1,000 (1 + 0.10)2 = $1,210

$2,000 (1 + 0.10)1 = $2,200
$500 = $500
= $3,910

TO SOLVE FOR THE PRESENT VALUE:

$1,000
1
= $909.09
(1 + 0.10)
$2,000
2
= $1,652.89
(1 + 0.10)
$500 $375.66
3
=
(1 + 0.10) $2,937.64

DETERMINING INTEREST RATES AND TIME FRAMES

As a financial advisor you may be asked such questions as:
1. “If I invested $1,000 today at 10% and wished to accumulate $5,000, how long would it take?”
2. “If I invest $1,000 now and want to have $86,736.22 in 20 years’ time, what rate of return will I require?”
3. “If I invest $1,000 a year at 10% and wish to accumulate $20,000, how long would it take?”
4. “If I invest $15,500 each year into an RRSP and want to have $1 million in 20 years, what would I have to earn
as a rate of return?”

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A • 14 FUNDAMENTALS OF FINANCIAL PLANNING

In the first two questions you are searching for either an interest rate or a time frame (using single amounts).
As pointed out earlier, in all cases you have four out of five pieces of information and are asked to find the one
unknown. The easiest way to solve these types of problems is to avoid the algebra and use either tables or a financial
calculator.

SOLUTION TO QUESTION 1:
“If I invested $1,000 today at 10% and wished to accumulate $5,000, how long would it take?”
To answer the question, consider what is known: interest I is 10% annually; the present value PV is $1,000; the
payment PMT is $0; the future value FV is $5,000; so, the only thing missing from the equation is N or the number
of years.

USING A FINANCIAL CALCULATOR:

Key Touch Display

10 I 10
–1,000 PV –1,000
0 PMT 0
5,000 FV 5,000
CPT N 16.89

The answer is 16.89 years. Note that the negative number for the present value (–$1,000) represents a cash outflow,
with the $5,000 as a future receipt (cash inflow).

SOLUTION TO QUESTION 2:
“If I invest $1,000 now and want to have $86,736.22 in 20 years’ time, what rate of return will I require?”

USING A FINANCIAL CALCULATOR:

Key Touch Display

20 N 20
–1,000 PV –1,000
0 PMT 0
86,736.22 FV 86,736.22
CPT I 25

The investor would have to earn 25% annually. The financial advisor may question the reasonableness, if earning
this rate of return. Note, again, that the negative number for the present value (–$1,000) represents a cash outflow,
with $86,736.22 as a future receipt (cash inflow).

SOLUTION TO QUESTION 3:
“If I invest $1,000 a year at 10% and wish to accumulate $20,000, how long would it take?” The investment is
$1,000 a year, so it must be an annuity. Again, the time frame needs to be calculated.

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 APPENDIX | FINANCIAL MATH A • 15

USING A FINANCIAL CALCULATOR:

Key Touch Display

10 I 10
0 PV 0
–1,000 PMT –1,000
20,000 FV 20,000
CPT N 11.53

It would take 11.53 years to accumulate $20,000. Keep in mind that the negative number for the payment
(–$1,000) represents a cash outflow, with the $20,000 a future receipt (cash inflow).

SOLUTION TO QUESTION 4:
“If I invest $15,500 each year into an RRSP and want to have $1 million in 20 [Link] would I have to earn as a
rate of return?”
In this instance, the interest rate of an annuity is to be calculated. In finance capital budgeting questions, this is
sometimes called the internal rate of return.

USING A FINANCIAL CALCULATOR:

Key Touch Display

20 N 20
0 PV 0
–15,500 PMT –15,500
1,000,000 FV 1,000,000
CPT I 11.04

To become a millionaire, the investor would have to earn 11.04% each year for 20 years. Here, the $15,500
contribution is a negative number (a cash outflow) and the $1,000,000 is a positive number (cash inflow).

PRESENT AND FUTURE VALUES OF MULTIPLE CASH FLOWS

Frequently, financial advisors encounter present and future value questions involving regular cash flows, known as
annuities. Annuities, by definition, assume the same cash flows over a specified period of time. Regular annuities
assume that payments or receipts start in one year’s time. They are referred to as annuities in arrears or ordinary
annuities. If an annuity starts immediately, it is known as an annuity due. If an annuity starts somewhere in the
future (beyond year one), it is known as a deferred annuity. Annuities can best be explained using the following
examples:

EXAMPLE
If you deposited $1,000 each year for three years in a savings account that earned 4% per year, how much would
you have immediately after making the last deposit? How much would you have if the deposits were made in
advance (starting immediately)?
To start the solution a time line will be used. Time lines are used to help visualize when cash inflows and outflows
occur over a given time period.
0.........................................1 .................................2 ..................................3
? 1,0001,000 1,000

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A • 16 FUNDAMENTALS OF FINANCIAL PLANNING

EXAMPLE
Cont'd
One method for solving the question would be to treat each $1,000 separately, finding each separate future
value, then adding the values together.

Year 1 $1,000 (1 + 0.04)2 = $1,081.60

Year 2 $1,000 (1 + 0.04)1 = $1,040.00
Year 3 $1,000 = $1,000.00
= $3,121.60

Note that the last value in the annuity is not compounded. However, since the values are all the same, the approach
can be reduced to the formula:
 1 + i n − 1
( ) 
FV ( an) = PMT ×  
i
Where:
FV(an) = the future value of an annuity
PMT = payments or dollars per
i = the interest rate
n = the number of periods

Applying the formula:

 1 + i n − 1
( ) 
FV ( an) = PMT ×  
i
 1 + 0.04 3 − 1
( ) 
= $1,000 ×  
0.04

To raise (1 + 0.04) to the power of 3: enter 1.04, 2nd, yx, 3, = 1.124864

[1.124864 − 1]
FV ( an) = $1,000 ×
0.04
= $1,000 × (3.1216)

= $3,121.60

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

3 N 3
4 I 4
0 PV 0
–1,000 PMT –1,000
CPT FV 3,121.60

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 17

The negative number represents a deposit (outflow), with the $3,121.60 as a future receipt (cash inflow).
How much would you have if the deposits were made in advance (starting immediately)? This would be a case of an
annuity due. Note that there are still only three deposits of equal value, and the financial advisor is looking for the
value in Year 3.
0.........................................1 .................................2 ..................................3
1,000 1,000 1,000 ?

Again, each deposit could be treated separately, and then totalled:

$1,000 (1 + 0.04)3 = $1,124.86

$1,000 (1 + 0.04)2 = $1,081.60
$1,000 (1 + 0.04)1 = $1,040.00
= $3,246.46

Rule: The future value of an annuity due will always be greater than the future value of an ordinary annuity.
Unfortunately, if the annuity is very long the calculations can become tedious and prone to error. The following
formula is an alternative, but the calculator is handier. To adjust the future value formula from an ordinary annuity to
an annuity due, compound the ordinary annuity by an additional year (multiply by 1+i). This modification results in:
 1 + i n − 1 1 + i
( ) ( )
FV ( an) = PMT ×  
i

Solving the annuity due problem algebraically:

 1 + i n − 1 1 + i
( ) ( )
FV ( an) = PMT ×  
i
 1 + 0.04 3 − 1 1.04
( ) ( )
= PMT ×  
0.04
[1.12486 − 1](1.04)
= 1,000 ×
0.04
= $3,246.46

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

3 N 3
4 I 4
0 PV 0
–1,000 PMT –1,000

Set the calculator on the beg mode, as the payments start immediately with an annuity due.

Key Touch Display

CPT FV 3,246.46

© CANADIAN SECURITIES INSTITUTE (2020)

A • 18 FUNDAMENTALS OF FINANCIAL PLANNING

PRESENT VALUE OF AN ANNUITY

Instead of having to find the future value of a series of cash flows, the financial advisor may have to find an amount
that is needed to finance a series of cash flows.

EXAMPLE
An insurance company wishes to sell an annuity that will pay the recipient $1,000 a year for three years. The
company wants to earn 10% on the annuity. What would be the price of this annuity?
The question asks: What is the present value of an annuity of $1,000 discounted at 10%? To start the solution a
time line will again be used:
0.........................................1 .................................2 ..................................3
? 1,000 1,000 1,000

Again, one method for solving the question would be to treat each 1,000 separately, finding each present value
and then adding the values together.
$1,000
1
= $909.09
(1 + 0.10)
$1,000
2
= $826.44
(1 + 0.10)
$1,000 $751.32
3
=
(1 + 0.10) $2,486.85

An annuity formula can also be used. The present value of an annuity formula:

PV ( an) = PMT × (1 − Present Value Factor ) i



{
n 
= PMT ×  1 − 1 (1 + i )  i

}
Where:
PMT = dollars per period
i = discount rate
n = number of periods

The expression for the annuity present value factor may look a little complicated, but it is not difficult to use. The
{1/(1+i)n} part of the present value equation is the same as calculating the present value interest factor.


3 
{
PV ( an) = $1,000 ×  1 − 1 (1 + 0.10)  0.10

}
1
PV ( an) = $2,486.85

1
Working from the innermost brackets out:
(1
+ 0.10)3 is 1.1, 2nd, Yx, 3 = 1.331
1
/ 1.331 is 0.75131
1
– 0.7513 is 0.2487
0.2487
/ 0.10 is 2.48685
PV
(an) = $1,000 (2.48685)
=
$2,486.85

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 19

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

3 N 3
10 I 10
–1,000 PMT –1,000
0 FV 0
CPT PV 2,486.85

LOANS AND MORTGAGES

Present value techniques can be used to determine the amount of loan payments, the interest charged on loans and
the payout on a loan.

EXAMPLE 1
You borrow $5,000 from the bank today, to be paid off over the next five years, in equal annual instalments.
What is the dollar value of the instalments, if the bank quotes you an interest rate of 12%? If the bank across the
street asks for $1,527 annually, what interest rate is it charging?

The present value of the loan is the amount that you would receive, $5,000. N would be 5, and in the first case
scenario, i would be 12%. Substituting into the present value of an annuity formula (it is an annuity since the
instalments are equal) and solving for PMT:


{ n 
}
PV ( an) = PMT ×  1 − 1 (1 + i )  i



{ 5 
$5,000 = PMT ×  1 − 1 (1 + 0.12)  0.12

}
$5,000 = PMT × [3.60477 ]

PMT = $5,000 3.60477 = $1,387.05

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

5 N 5
12 I 12
5,000 PV 5,000
0 FV 0
CPT PMT –1,387.05

In the second part of the question, you are told that the payments will be $1,527, N still remains at five and the
present value is still $5,000. Solving for i, using the formula would require using logarithms, so a financial calculator
will be used.

© CANADIAN SECURITIES INSTITUTE (2020)

A • 20 FUNDAMENTALS OF FINANCIAL PLANNING

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

5 N 5
5,000 PV 5,000
–1,527 PMT –1,527
0 FV 0
CPT I 15.999*
* With some business calculators you will get an error message, unless you enter the payments as a negative number (a cash outflow).

EXAMPLE 2
What would be the effective rate on a $1,000 loan, at a quoted annual rate of 10%, but interest compounded
monthly?
The $1,000 may have thrown you off because you wanted to enter it “somewhere,” but to answer the question
you have to convert a quoted or nominal rate to an “effective rate,” discussed earlier. Recall that the formula was:
nf
EAR =  1 + (Quoted Rate) f  − 1

Solution:
1×12
EAR = [1 + 0.10 12] −1
12
= [1 + 0.008333] − 1

= 1.104713 − 1

= 0.104713 or 10.47%

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

12 (x,y) 0.00
10.00 2 , EFF
nd
10.47

If a department store charged 20% annually, but compounded daily, what would be the effective rate?

Key Touch Display

365 (x,y) 0.00
20.00 2 , EFF
nd
22.13

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

EXAMPLE 3
Assume that you want to borrow $10,000 for four years. The bank charges you 10%, compounded monthly.
What would be your monthly payment? A blended payment loan is an annuity from the lender’s perspective.
Therefore, the annuity formula can be used to solve loan-payment problems. After two years, what would be the
balance owing (the payout on the loan)?

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 21

EXAMPLE 3
Solution:
You borrow $10,000 today (PV = 10,000), N = 4 × 12 = 48, translated as 48 loan payments, the monthly interest
factor would be: i =0.10/12 = 0.008333. What would be your monthly payment?


{ n 
PV ( an) = PMT ×  1 − 1 (1 + i )  i

}


{ 48 
$10,000 = PMT ×  1 − 1 (1 + 0.10 12)  0.008333

}


{ 48 
$10,000 = PMT ×  1 − 1 (1.008333)  0.008333

}
$10,000 = PMT ×  1 − {1 1.4894} 0.008333

$10,000 = PMT × [1 − 0.6714 ] 0.008333

$10,000 = PMT × 39.432

PMT = $10,000 39.432 = 253.61

Key Touch Display

48 N 48 (4 years × 12)
0.8333 I 0.8333 (10/12 = 0.8333)*
10,000 PV 10,000
0 FV 0
CPT PMT 253.63

After two years, what would be the balance owing (the payout on the loan)? One method for calculating the
payout is to calculate the present value of all the remaining payments. In this case, there are only 24 payments of
$253.63 each outstanding; i still remains at 0.008333, for formula purposes.


{ n 
PV ( an) = PMT ×  1 − 1 (1 + i )  i

}


{ 24 
PV = 253.63 ×  1 − 1 (1 + 0.10 12)  0.008333

}


{ 24 
PV = 253.63 ×  1 − 1 (1.008333)  0.008333

}
PV = 253.63 ×  1 − {1 1.22038} 0.008333

PV = 253.63 × 21.6708

PV = $5,496.37

* Note that you do not divide 0.10 by 12 (i.e., entering 0.008333 would be incorrect). The calculator assumes that when you enter a
percentage, so the correct entry is 0.83333 (0.10/12 × 100).

© CANADIAN SECURITIES INSTITUTE (2020)

A • 22 FUNDAMENTALS OF FINANCIAL PLANNING

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

24 N 24
0.8333 I 0.8333
253.63 PMT 253.63
0 FV 0
CPT PV 5,496.40

MORTGAGES:
Mortgage calculations offer a new spin to present value calculations. Since a mortgage is essentially a loan with
“equal payments,” the present value of an annuity formula will be used. However, in Canada, mortgages are
compounded semi-annually, with interest paid monthly. This means that the interest factor i must be adjusted. In
the following numeric example, the calculations will move from the simplistic to the more complex:

EXAMPLE 1
A client tells you that he wants to buy a house. The family can afford payments of about $2,000 a month.
The bank will give a mortgage amortized over 25 years at 8.5%. At about what price level should the client be
looking?*
* For simplicity it is assumed that the client has the down payment and meets the required service ratios.

Since this will only be an approximation, the present value calculation will be done using a simple annual rate of
8.5%, with N equal to 25 years, and the annual payments will be 12 × $2000 = $24,000. Semi-annual compounding
and monthly mortgage payments have been ignored.


{ 25 
PV ( an) = PMT ×  1 − 1 (1 + 0.085)  0.085

}
= $24,000 ×  1 − {1 7.6868} 0.085

= $24,000 × (0.86990 0.085)

= $245,618

Given the limitations on the family budget, the value of the new house should not exceed approximately $245,600.

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

25 N 25
8.5 I 8.5
24,000 PMT 24,000
0 FV 0
CPT PV –245,620.58

However, to be more precise, the financial advisor must adjust for semi-annual compounding and monthly
payments. Monthly payments are easy, since the financial advisor need only multiply 12 months times the number

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 23

of years in the mortgage. However, the monthly interest factor requires more consideration. In this case, the
formula for calculating the monthly mortgage interest factor is:
2 12
Mortgage interest factor = (1 + i 2) − 1 × 100

The 2/12 (or 0.16667) exponent represents semi-annual compounding, with monthly payments. Rounding to less
than four or five decimal places will significantly alter the results.

USING THE CALCULATOR:

Key Touch Display

1.0425 2 , y , 0.16667 =
nd x
1.006961

The mortgage factor, therefore, becomes: 1.006961 – 1 or, 0.006961.

Alternatively, the mortgage interest factor can be solved using the interest rate conversion feature on your
calculator:
Key in 2 (x,y) 8.5 2nd EFF 8.680625
Key in 12 (x,y) 8.680625 2nd APR 8.3532745
8.3532745 ÷ 12 = 0.6961062

If a financial calculator is to be used, the interest factor must be multiplied by 100, since the calculator
automatically reduces the number to a percentage.

USING THE FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

300 N 300 (12 months × 25 years)
0.6961 I 0.6961 (0.006961 × 100)
2,000 PMT 2,000
0 FV 0
CPT PV 251,458.93

EXAMPLE 2
Alternatively, a client may state that she is considering a new house that costs $200,000 and wants you to tell
her what this means to her monthly budget. Assume, in this case, that mortgage rates are 8% and the term will
be for 25 years. If a quick approximation is required, the present value of an annuity formula can be used.


{ n 
PV ( an) = PMT ×  1 − 1 (1 + i )  i

}


{ 25 
$200,000 = PMT ×  1 − 1 (1 + 0.08)  0.08

}
PMT = $18,736

$18.736 12 months = $1,561.31 per month

Recognizing semi-annual compounding and monthly payments (and using the financial calculator):
2 12
Mortgage interest factor = (1 + i 2) − 1 × 100

© CANADIAN SECURITIES INSTITUTE (2020)

A • 24 FUNDAMENTALS OF FINANCIAL PLANNING

I IS THE ANNUAL NOMINAL INTEREST RATE:

Key Touch Display

1.040 2 , y , 0.16667 =
nd x
1.00655833

Subtracting 1, and multiplying by 100, the i for the calculator is: 0.655833. Set this number aside to be used later.

USING A FINANCIAL CALCULATOR:

Key Touch Display

300 N 300
0.655833 I 0.655833
200,000 PV 200,000
0 FV 0
CPT PMT –1,526.45

MIXING SINGLE AMOUNTS AND ANNUITIES

Problem solving is not always straightforward. In this section, problems will require two separate (or more)
calculations. Try the following:
A certain cash flow is expected to start in Year 11 and continue each year to Year 20.
The dollar amounts would be the same each year – $200. If the discount rate on this stream of payments was set at
6%, what would this stream be worth today?
If you recognized this as a deferred annuity you would be correct. The cash flow does not start one year out, it starts
in 11 years. The time line would be as follows:
1-9....10 ...............11.............12.............13............14.............15.............16.............17............18.............19.............20
? 0 200 200 200 200 200 200 200 200 200 200
To make the problem easier, break the problem into two parts. First solve for the value of the annuity as if it started
one year away, just as if it were an ordinary annuity. Then, after reducing it to a single amount, bring that amount
back to period zero.

STEP 1: PRESENT VALUE OF THE ANNUITY:

To make this easier to visualize, reduce all annuity time values by 10 (10-10 becomes time period 0, etc.) and redraw
the time lines:
0 ...............1...............2...............3..............4...............5...............6...............7..............8...............9...............10
? 200 200 200 200 200 200 200 200 200 200



n 
PV ( an) = PMT ×  1 − 1 (1 + i )  i

{ }


{ 10 
= 200 ×  1 − 1 (1 + 0.06)  0.06

}
= 200 ×  1 − {1 1.7908} 0.06

= 200 × [7.359839]

= 1,472

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 25

The second step is to realize that the total present value of the annuity is $1,472, at Year 10, not at Year 0. The
second step is to discount the $1,472 (a single amount) back a further 10 years.
0 .........................................................................................................................................................................10
? $1,472
10
PV = 1,472 (1 + 0.60)

= 1,472 1.79085 = $821.56

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

10 N 10
6 I 6
200 PMT 200
0 FV 0
CPT PV –1,472.02 (Store or set aside)

CLEAR THE CALCULATOR.

Key Touch Display

10 N 10
6 I 6
0 PMT 0
1,472 FV 1,472
CPT PV –821.96

Another typical financial planning question deals with the cost of a child’s university education. A child wishes to
begin a four-year university program in five years’ time. How much would have to be set aside today as a lump
sum in order to finance these four years, if the approximate university costs were $10,000 each year (payable in
advance). Assume that the client can earn 7%.
It would be wrong to say that university would cost $40,000 ($10,000 × 4), since the calculation fails to take into
account the time value of money. Secondly, not all of the $40,000 is paid out in the first year. Only $10,000 is paid
out and the remaining balance continues to earn interest at 7%. So the total cost of university must be less than
$40,000.

STEP 1: HOW MUCH WILL UNIVERSITY COST?

0 ................1...............2...............3...............4...............5...............6 ...............7 ...............8
10,000 10,000 10,000 10,000

This is a four-year deferred annuity, and the client needs to know the cost (i.e., the present value of the four $10,000
payments). However, since the payments are in “advance” at the beginning of the year, the formula for the present
value of an annuity due can be used.

© CANADIAN SECURITIES INSTITUTE (2020)

A • 26 FUNDAMENTALS OF FINANCIAL PLANNING



{
n 
PV ( an) = PMT ×  1 − 1 (1 + i )  i × (1 + i )

}


{4 
= $10,000 ×  1 − 1 (1 + 0.07)  0.07 × (1.07)

}
= $10,000 ×  1 − {1 1.3108} 0.07 × (1.07)

= $10,000 × [3.3872] × (1.07)

= $33,872.44 × (1.07) = $36,243.16

0................1 ...............2 ...............3 ...............4 ...............5

? $36,243.16

STEP 2: HOW MUCH DOES THE CLIENT HAVE TO PUT ASIDE NOW (TIME PERIOD 0)?
5
PV = $36.243 (1 + 0.07)

= 36,243 1.40255 = $25,840.78

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

4 N 4
7 I 7
10,000 PMT 10,000
0 FV 0

SET THE CALCULATOR ON THE BEG MODE, AS THE PAYMENTS ARE IN ADVANCE
(I.E., AT THE BEGINNING OF THE YEAR).

Key Touch Display

CPT PV –36,243.16 (Set aside or store)

CLEAR THE CALCULATOR (BGN SHOULD NOT APPEAR ON SCREEN).

Key Touch Display

5 N 5
7 I 7
0 PMT 0
36,243.16 FV 36,243.16
CPT PV –25,840.87

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 27

If you have a problem with the present value annuity due calculations, simply calculate the present value of a three-
year ordinary annuity (the end mode is used for the payments), and then add on the payment made in advance.
PV = $10,000 + PV of $10,000 for three years, discounted at 7%.

Key Touch Display

3 N 3
7 I 7
10,000 PMT 10,000
0 FV 0
CPT PV –26,243.16

$26,243.16 + $10,000 = $36,243.16

If the client invested a lump sum of $25,840.87 today at 7%, he would have $36,243.16 in five years. This will
allow the child to withdraw $10,000 a year for four years, starting at the beginning of the school year. After the last
$10,000 withdrawal, to cover the final year, the balance would be zero.
If instead, the client asked how much would he have to set aside each year (starting in one year’s time), in order to
meet his child’s educational requirements, how would the financial advisor calculate the amount?
From the previous calculations, the financial advisor knows that the client will need $36,243.16 in five years’ time (a
future value). The issue now is to calculate the amount that needs to be set aside each year, so that $36,243.16 can
be accumulated in five years. To solve this question, use the future value of an annuity formula.
n
(1 + i ) − 1
FV ( an) = PMT ×
i
5
(1 + 0.07) − 1
$36,243.16 = PMT ×
0.07
$36,243.16 = PMT × (5.7507)

PMT = $6,302.39

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

5 N 5
7 I 7
0 PV 0
36,243.16 FV 36,243.16
CPT PMT –6,302.35

Again, the negative result indicates annual cash outflows or deposits of $6,302.35 would accumulate to $36,243.16
over a period of five years.

© CANADIAN SECURITIES INSTITUTE (2020)

A • 28 FUNDAMENTALS OF FINANCIAL PLANNING

VALUING SECURITIES USING TIME VALUE

Time value calculations play an important role in pricing securities; a stripped bond is a good example. A financial
advisor may use time value to calculate the rate of return that an investor would get, if the investor purchases a
strip bond at its current price and holds it to maturity; or, a financial advisor can calculate a strip bond’s market
value given current interest rates. Consider the following:

EXAMPLE 1
A seven-year, $1,000 par value, strip bond is selling in the marketplace for $513.16. If a client purchases it today
and holds it to maturity, what would be the investor’s rate of return?
Since the PV ($513.16), FV ($1,000 at maturity), and N (7 years) are known, the only unknown is i, the interest
rate. Substituting into the future value formula (single amount):
n
FV = PV × (1 + i )
7
$1,000 = $513.16 × (1 + i )
7
1.9487 = (1 + i )

1 + i = 1.94871 7

i = 1.099985 − 1

i = 10%

To solve for the value of 1.9487 raised to the power of 1/7:

Key Touch Display

1.9487 2 ,ynd x
0.00
7 2 , 1/x =
nd
1.0999985

Using a financial calculator:

Key Touch Display

7 N 7
–513.16 PV –513.16
0 PMT 0
1,000 FV 1,000
CPT I 9.999

© CANADIAN SECURITIES INSTITUTE (2020)

 APPENDIX | FINANCIAL MATH A • 29

EXAMPLE 2
What would be the theoretical market value of a 10-year, $1,000 par value strip bond, if investors were using a
10% discount rate?
Once again, the discount rate, the time frame and the future value are known. Using the present value formula:
n
PV = FV (1 + i )
10
= $1,000 (1.10) = 385.54

Using a financial calculator:

Key Touch Display

10 N 10
10 I 10
0 PMT 0
1,000 FV 1,000
CPT PV –385.54

PRESENT VALUES OF PERPETUITIES

How do you price a cash flow that is expected to continue forever, with no change? What type of security would
produce this cash flow?
To answer these questions it is easier to answer the second question first. A preferred share pays a fixed dividend
and since it is, technically, an equity security it has no maturity date. To calculate the present value of a perpetuity:
PV = PMT/ i

Where:
PMT is the annual dividend and i is the rate of interest paid on investments of similar risk characteristics.

What would be the price of a preferred share that paid $1 in dividends and the market rate for similar preferred
shares was 10%?
PV = $1/0.10
PV = $10

This formula is an abbreviation of the Dividend Discount Model. Since there is no growth in preferred share
dividends, (g = 0), the DDM formula of P = Dividend per share / r – g (where r is the discount rate and g is the
dividend growth rate) is shortened to: D/i or PMT/i.

PRICING BONDS
Bond pricing requires the calculation of the expected coupon payments (present value of an annuity) and the
present value of the par or face value at maturity. In other words, it mixes two present value techniques and requires
two different formulas.

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A • 30 FUNDAMENTALS OF FINANCIAL PLANNING

EXAMPLE 1
What is the present value of a one-year 6% coupon $1,000 par value bond? Assume that the market rate on
bonds of similar risk is 6%, and interest is paid annually.
Solution: In one year’s time the bond will be worth $1,060 ($1,000 par value and $60 in accumulated interest).
Using the present value of a single amount formula:
10
PV = $1,060 (1 + 0.06)

PV = $1,000

EXAMPLE 2
What is the present value of a one-year bond with a $1,000 par value, a 4% coupon rate paid annually,
discounted at 6%?
Solution: In one-year the bond will have a value of $1,040 ($1,000 par value and $40 in interest).
10
PV = $1,040 (1 + 0.06)

PV = $981.13

EXAMPLE 3
What is the present value of a one-year bond with a $1,000 par value, a 4% coupon rate paid annually,
discounted at 2%?
1
PV = $1,040 (1 + 0.02)

PV = $1,019.61

The previous three examples illustrate the relationship between the market interest rate and bond prices. When
market rates rise above the coupon rate, the value of the bond falls below par, and vice versa.

EXAMPLE 4
What is the present value of a one-year bond with a $1,000 par value, a 4% coupon interest paid semi-annually,
discounted at 6%?

The cash flows would be as follows:

0.........................6 months ..................1 year
PV $20 $20
$1,000

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 APPENDIX | FINANCIAL MATH A • 31

This problem may be solved by treating each value separately or combining the last interest payment with
the principal.
FV 1 FV 2
PV = 1
+ 2
(1 + i ) (1 + i )

Where:
PV = present value
FV1 and FV2 = adjusted future values, the coupon payments of (4% × $1,000 par ) / 2,
or two, semi-annual $20 payments
i = adjusted discount rate 6% /2 = 3%
n = adjusted number of time periods from present to the coupon being calculated
(two interest payments during the year)

The rule for multiple compounding is: divide i by the number of compounding periods, and multiply n by the same
number. Solving for the bond’s market price:
$20 $1,020
PV = 1
+ 2
(1 + 0.03) (1 + 0.03)
$20 $1,020
PV = + = $980.87
1.03 1.0609

USING A FINANCIAL CALCULATOR:

Key Touch Display

2 N 2
3 I 3
20 PMT 20
0 FV 0
CPT PV –38.26939
1,000 FV 1,000
CPT PV –980.87

Note that with the financial calculator, the calculator automatically assumes that the $1,000 future par value takes
place in two years, and that the same discount rate applies. It is especially important to remember to clear the
calculator before the next series of calculations or the time and discount rate will be carried forward into the next
calculation, contaminating it.

EXAMPLE 5
What is the present value of a two-year bond with a $1,000 par value, a 6% coupon, interest paid semi-annually,
discounted at 10%?
Solution: The time line would be as follows:
0.........................6 months ..................12 months ................18 months ................24 months
PV $30 $30 $30 $30
$1,000

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A • 32 FUNDAMENTALS OF FINANCIAL PLANNING

One way to solve the problem would be to treat each value separately, and then add all the amounts together.
$30 $30 $30 $1,030
PV = 1
+ 2
+ 3
+ 4
= $929.08
(1 + 0.05) (1.05) (1.05) (1.05)

USING A FINANCIAL CALCULATOR (CLEAR THE CALCULATOR):

Key Touch Display

4 N 4
5 I 5
30 PMT 30
0 FV 0
CPT PV –106.38
1,000 FV 1,000
CPT PV –929.08

Since the discount rate is higher than the coupon rate, the calculated amount appears “reasonable.” If the
calculated result was above $1,000, there would have to be an error.

© CANADIAN SECURITIES INSTITUTE (2020)